In its first inspection report of a Big Four firm in the year 2010, the PCAOB just released its 2009 inspection report of Deloitte & Touche LLP, finding quite a high percentage of errors in the sample of audits selected to be reviewed.

The Public Company Accounting Oversight Board on May 4, 2010 conducted an inspection of the registered public accounting firm Deloitte & Touche LLP (“Deloitte” or “the Firm”) in 2009, and issued a report in accordance with the requirements of the Sarbanes-Oxley Act of 2002.

Here are some interesting facts and numbers from this report summary:

Members of the Board’s inspection staff conducted primary procedures for the inspection from October 2008 through October 2009.

Field work was done at Deloitte’s National Office and at 30 of its approximately 69 U.S. practice offices, indicating about 40% of offices were covered.

The scope of this review was determined according to the Board’s criteria, and the Firm was not allowed an opportunity to limit or influence the scope.

The inspection reviewed aspects of 73 audits performed by Deloitte and found 15 issues (Issues A to O), which works out to a 20% error rate, by simply dividing 15 by 73, which we would think is quite high. Imagine that one of every five audits randomly selected and signed off by one of the largest accounting firms on the planet has purported errors.

We summarize below all the 15 issues, which PCAOB calls, “audit deficiencies, including failures by the Firm to identify or appropriately address errors in the issuer’s application of GAAP, including, in some cases, errors that appeared likely to be material to the issuer’s financial statements. In addition, the deficiencies included failures by the Firm to perform, or to perform sufficiently, certain necessary audit procedures.” – so quite stringent in its scope.

Issuer A
The issuer’s total U.S. net federal deferred tax assets, which exceeded its
stockholders’ equity at year end, included substantial U.S. income tax net operating loss
carry forwards for which no valuation allowance had been recorded. The Firm, however, failed to give sufficient weight to relevant evidence that was more objectively verifiable, such as the fact that the issuer had experienced losses in seven of the last eight years (including cumulative losses in the last three years), had experienced two successive year-over-year declines in U.S. sales volumes, and considered the disruptions in the financial markets to be a risk factor to its business.

Issuer B
The issuer evaluated its recorded goodwill for impairment during the third quarter
of the year and concluded that the fair value of its total assets exceeded their book
value by a small margin. The Firm failed to sufficiently evaluate the effect of these events on its assessment of the potential impairment of goodwill at year end.

Issuer C
The Firm failed in the following respects to obtain sufficient competent evidential matter to support its audit opinion, in failing to perform adequate audit procedures to test the valuation of the issuer’s inventory and investments in joint ventures (the primary assets of which were inventory). Etc.

Issuer D
The Firm failed to adequately test the valuation of the issuer’s inventory and the issuer’s investments in unconsolidated entities, whose primary assets were inventory (“investments”).

Issuer E
The Firm failed to adequately test an intangible asset for impairment.

Issuer F
The Firm failed to perform adequate audit procedures pertaining to a sale of a subsidiary to a newly formed entity in which the issuer held an ownership
interest.

Issuer G
The Firm failed in the following respects to obtain sufficient competent evidential matter to support its audit opinion, in one reporting unit, the Firm failed to evaluate
whether management’s use of historical results as the sole basis for its revenue
projections, without considering the issuer’s future prospects or the economic
conditions, was reasonable.

Issuer H
The issuer engaged a specialist to calculate the estimated amount of a significant
contingent liability. The amount calculated by the specialist exceeded the amount
recorded by the issuer by an amount that was approximately 13 times the Firm’s
planning materiality. The Firm failed to perform sufficient procedures to test the
contingent liability.

Issuer I
The Firm failed to perform adequate audit procedures to test the issuer’s conclusion that certain available-for-sale securities with unrealized losses did not require a charge for other-than-temporary-impairment.

Issuer J
The Firm failed to evaluate the reasonableness of certain significant
assumptions that the issuer had used in developing its cash flow estimates to assess
the recoverability of certain long-lived assets etc.

Issuer L
The issuer acquired a company during the year, and this acquired company
operated as a subsidiary of the issuer after the acquisition and was the source of a
significant portion of the issuer’s reported revenue. The Firm failed to test the
operating effectiveness of the controls over the acquired company’s revenue and, as a
result, the Firm’s testing of revenue was inadequate.

Issuer M
The Firm failed to perform adequate audit procedures to test the fair
value of an embedded derivative liability at year end.

Issuer N
The Firm failed to sufficiently test revenue and cost of goods sold.

Issuer O
The Firm failed to identify a departure from GAAP that it should have identified and addressed before issuing its audit report.

In its response to the PCAOB, Deloitte said, “We have evaluated the matters identified by the Board’s inspection team for each of the Issuer audits described in Part I of the Draft Report and have taken actions as appropriate in accordance with D&T’s policies and PCAOB standards….none of our reports on the Issuers’ financial statements was affected.”

A few things stand out in this report:

First, the PCAOB is actually providing the sample size of the inspected audits, for the first time, enabling us to calculate an error rate

The error rate in this situation is quite high, almost one of every five audits has errors. Obviously, Deloitte performs thousands of audit each year and extrapolating from a small sample is quite dangerous, nonetheless, even at half of 20%, the natural conclusion is that one in ten audits has an error, and would have gone unnoticed had not the PCAOB done a good post-audit on the audit.

Finally, there is a good deal of variance in the type of errors found, ranging from lack of inventory checking to impairment testing. Interesting to see that not all of these issues related to accounting for financial securities.

We’ll of course be waiting for the report on Ernst & Young to see if the PCAOB is highlighting any accounting deficiencies relating to its audit of Lehman Brothers’ infamous Repo 105, if that were indeed in the scope of the 2009 audit.

PCAOB, Deloitte, inspection report., 2010, audit, issues, inventory

May 6, 2010

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